2015 Volume 1

RED FLAGS: Incidence and Interpretation

Detrimental information is revealed in 17% of due diligence background investigations. Infractions range from local suits to federal cases, along with credentials misrepresentation, personal problems (substance abuse, family discord) and serious financial issues.

Severity of Infractions
A manager's criminal record or bankruptcy may seem like obvious reasons to invest elsewhere, but other issues can be murkier to interpret.

The organization's mission will be a factor. A more conservative institutional investor may balk at a seemingly minor infraction that another firm would overlook.

Relevance, Frequency and Timing
Federal RICO and SEC Act of 1934 violations are of great concern, as are suits brought by former business partners, employers or investors, particularly if the charges are serious or if the manager was directly involved.

Open cases or recent litigation should be analyzed carefully. In addition to the actual legal issues, the fund itself could be at risk, or the proceedings could divert the manager's attention away from an investment.

Multiple infractions deserve heightened scrutiny. Are they an indicator of a manager's aggressive "style," or do they possibly reveal character flaws that may not meet an investor's risk protocols or investment philosophy?

An old court case does not necessarily raise a red flag, particularly if it is unrelated to the current business.

Personal Issues
Recently there have been multiple news stories regarding high profile fund manager divorces, detailing acrimonious issues and even some ground-breaking court opinions.

Consider the following regarding a manager divorce situation:

  • Will the manager be able to focus despite the proceedings?
  • Are there broader legal, financial or personal issues?
  • Does the ex-spouse have a stake in firm ownership or a role in its operations?

Regulatory Sanctions
Ongoing investigations or past sanctions by regulatory agencies are serious red flags.

A real example of this is a recent Freedom of Information Act Inquiry that revealed that the SEC was actively investigating a fund. This tipped off our client to obtain more details about the violations from the manager, and as a result, it chose not to invest. The fund ultimately collapsed, and our client was spared the potential loss of its multi-million dollar investment.

It is important to note that the magnitude of the fine for a past violation is not always a reliable indicator of the severity of the infraction.

Our analysis of many prior fund blow-ups revealed a strong correlation to regulatory sanctions and criminal or civil suits, in addition to substandard financial practices. Several of them also involved significant personal problems.

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